ECB’s LTRO may carry key to risk rally

Credit crunch fears remain despite flood of liquidity

By

WilliamL. Watts

FRANKFURT (MarketWatch) — An averted funding crisis, a steep drop in Italian and Spanish borrowing costs and a global equity rally to boot — the European Central Bank’s December decision to flood the euro area’s financial system with long-term liquidity via inexpensive three-year loans has been credited with everything short of curing the common cold.

So it’s no surprise that investors are expected to be riveted to the second-ever three-year long-term refinancing operation, or LTRO, which will be conducted by the central bank this week.

“We can almost certainly expect further equity-market strength following the next LTRO, falling volatility and with it, a narrowing of spreads of troubled euro-zone issuers with respect to bund [safe-haven German government bond] yields. We might even possibly get a slight increase in bund yields as safe-haven concerns are reduced,” said Rob Carnell, chief international economist at ING Bank.

Doubts remain, however, about the ability of the operations to spur lending activity necessary to avoid a credit crunch across the troubled euro area, economists said.

And the operations may also be fostering unintended consequences, including a counterintuitive rise in the euro, that could hinder efforts by the euro-zone’s most debt-strapped countries to regain competitiveness, analysts said.

In its Dec. 21 LTRO, more than 500 banks stormed the ECB to borrow 489 billion euros ($657 billion) in three-year loans fixed at its refi rate, which stands at 1%. A second LTRO will be allotted on Wednesday, with the ECB expected to reveal the total amount around 11:15 a.m. Frankfurt time, or 5:15 a.m. Eastern.

Estimates on the size of the second LTRO cast a wide range. A recent Reuters survey found estimates ranging between €200 billion and €1 trillion. Read more.

Breaking the vicious cycle

The LTROs were announced by ECB President Mario Draghi in early December.

At the time, a familiar vicious circle was at work. European banks remained reluctant to lend to one another in the interbank market due to fears a weak institution somewhere in the euro zone could collapse, having been unable to secure crucial short-term funding.

That in turn amplified the region’s sovereign-debt crisis.

Fears that governments would be forced to rescue failing banks made investors reluctant to hold government debt, pushing up yields and raising borrowing costs for the likes of vulnerable governments, including Italy and Spain. Even so-called core bond yields were pushed higher, sparking worries the crisis was on the verge of taking a dangerous new turn.

The uptake of the first LTRO caught many analysts by surprise. Before long, the flood of liquidity appeared to be paying in dividends in easing stresses in bank funding markets.

Funding markets opened and broadened out, with banks issuing €46 billion of senior, unsecured debt since the beginning of the year, more than was seen during the previous six-and-a-half months, noted Huw Van Steenis, strategist at Morgan Stanley.

Relief was seen for some Spanish, Italian and French banks in particular. These institutions have managed to issue longer, unsecured paper in recent weeks, he said.

The flood of liquidity’s also credited with creating a popular new carry trade that has seen banks use the cheap liquidity to chase yield, snapping up previously beat down peripheral euro-zone debt.

Since the December LTRO, the yield on six-month Italian government paper fell by nearly 2.7 percentage points, while the two-year yield fell nearly 2.4 points, noted Luca Cazzulani, deputy head of fixed-income strategy at UniCredit Bank in Milan.

Italy’s 10-year yield (10YR_ITA) trades around 5.45%, down from around 7% in November and well above 6% — the level widely viewed as unsustainable — ahead of the LTRO.

Yields have also fallen sharply across the Spanish curve. And the yield premium demanded to hold Italian and Spanish government debt over safe-haven bunds has narrowed.

At the same time, the amount of money deposited overnight by banks at the ECB continues to hover near record levels, signaling that some banks prefer to hoard cash rather than lend in the interbank market.

The LTRO, along with a stronger run of U.S. economic data and signs of stabilization in the troubled euro-zone economy, contributed to a “risk-on” environment that’s fueled a global rally in equities.

Gauging the likely size, let alone the impact, of this week’s operation is complicated.

Banks probably covered their most urgent needs with December’s LTRO and will use the second one to cover further refinancing needs or to fund other opportunities, including fresh lending or financial investments, Cazzulani said, in a note.

“It is fairly tricky to assess the amount of demand stemming from such factors as it depends on individual institutions’ preferences. At the end of the day, it is up to banks to decide how much they want to bid,” he said.

At the same time, demand may be squelched somewhat by worries that tapping the LTRO carries a stigma, analysts said. Josef Ackermann, chief executive of Deutsche Bank AG (DBK)
DB, -3.99%
earlier this year declared that the German institution’s longstanding refusal to take any government money had burnished its reputation with clients.

That prompted a mocking response from Draghi, who without naming names, told reporters earlier this month that remarks implying LTRO participation comes with a stigma were little more than empty and hypocritical “statements of virility.” Read The Tell blog.

The ECB in February detailed a loosening of collateral requirements that could help expand participation. Banks must pledge collateral in return for the loans.

Prediction time

So how will the markets react?

Frank Oland Hansen, senior economist at Danske Bank in Copenhagen, said overall reaction is likely to be muted if the ECB allots a total in a range of €300 billion to €600 billion, while a smaller amount could undercut peripheral government bonds and pressure the euro.

Some strategists contend a large uptake could spook markets by signaling deeper troubles in the euro-zone banking system, but Hansen argues a large figure would likely trigger a substantial risk rally.

Morgan Stanley’s Van Steenis agreed.

“A larger expansion of liquidity would clearly be preferred by markets, although the exit strategy would be more challenging” for the ECB, he said.

Meanwhile, an easing of worries surrounding the banking sector has allowed the euro to bounce back after an initial January stumble took the shared currency below the $1.30 level versus the dollar. The euro jumped above $1.34 on Friday for the for the first time in three months. Read more in Currencies.

Such an appreciation may not be welcome, however, as troubled euro-zone countries struggle to regain competitiveness without currencies of their own to weaken.

“That’s the problem here,” said Stephen Gallo, head of market analysis at Schneider Foreign Exchange, in a note to clients. “The more successful the LTROs are at restoring some confidence between European banks and reigniting the risk trade, the more likely the euro is to appreciate beyond tolerable limits.”

G-20 to Europe: Find money, now!

(3:30)

Stern directives are given to European leaders by Group of 20 finance leaders. (Reuters photo: Bernardo Montoya.)

And the jury remains out on whether the LTROs will translate into increased lending as banks continue to deleverage in an effort to shore up their balance sheets.

Data released by the ECB on Monday backed up assertions the LTRO has helped fend off a major credit crunch — but also showed banks have yet to step up their private-sector lending, economists said.

After a steep fall of €35 billion in December, loans by euro-zone banks to non-financial businesses fell just €1 billion in January. Loans to households grew by €8 billion after a €7 billion decrease seen in December.

“The ECB will certainly be hoping that over the coming months banks use an increasing amount of the money borrowed [in the LTROs] to lend to businesses and households. Despite January’s lending data, there is still little evidence of a significant early boost in bank lending to the private sector,” said Howard Archer, chief European economist at IHS Global Insight.

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